Monday, December 5, 2011

China is without doubt the most important growth story in the life insurance world - as it is in so many other industries. A mid-sized market today - smaller than the Italian market - it will likely become one of the largest insurance markets globally in the next several years. With annual growth rates projected at around 19 percent, the Chinese life insurance market will be larger than Germany's by 2010, and by 2015, it will have overtaken the United Kingdom as the third-largest market in the world, after the United States and Japan. Of course, this will not be straight-line growth, and there will be volatility along the way, but we are convinced that the growth of the life insurance market is broad-based and founded on solid fundamentals.

The high national savings rate, and the enormous pace at which the economic development of China is producing households that for the first time have the means to invest in savings and protection products, will continue to fuel growth for a long time.

First, China currently has about 12 million households with an income of more than US$10,000, mostly in urban centers, and this figure is expected to increase nearly sevenfold over the next five years.

Second, the economic development is spreading from the urban centers where it started - the Pearl River (around Shenzhen), the Yangtze Delta (around Shanghai), and in the area of Beijing - westward to reach deep into the hinterland, where the majority of the population currently resides. In absolute terms, most of the growth in Chinese life insurance will come from second- and third-tier cities and even rural areas.

On the distribution side, the big growth story of the last five years was the explosion of insurance sales through banks. Bancassurance accounted for 40 percent of 2005 first year premium (FYP) and 55 percent of 2006 FYP, a 42 percent increase. Over the same period, year-on-year growth of FYP was only 3.6 percent. It is not hard to see the reasons behind this.

Chinese bank branches have long been underutilized distribution channels, mainly serving as collectors of deposits from retail and corporate customers, and lenders to local companies and government entities. In the last few years, with an increasing emphasis on fee-based income, banks have mobilized their branches to sell retail financial products, of which bancassurance became the big focus.

However, sustaining profitability in this channel for life insurers looks increasingly challenging. As in many markets, the banks have realized they are in a strong negotiating position and are getting the lion's share of margins. For the insurers, the marketshare numbers and growth often mask the less attractive profit numbers.

In terms of products, investment-linked policies grew at a combined annual rate of 27 percent while the market, overall, grew at 17 percent annually during the period 2002 - 07. Similar to other Asian markets, the investment appetite of Chinese customers remains strong. Meanwhile, some insurers are dabbling in the still nascent health insurance segment. While China has started to rebuild its state welfare system with some basic pension and healthcare provision, the Chinese are well aware that this is very basic cover at best. As the middle class emerges, they will likely seek greater protection.

We are not alone with this assessment of China's growth potential. Every major multinational insurance company has made the Chinese market a priority for expansion. As of June 2008, eight of the world's top 10 insurance companies by revenues have already entered in China. However, strict regulation, limiting foreign companies' development of the Chinese market, has benefited the local players.

When China joined the World Trade Organization (WTO), it agreed to open its insurance market, in stages, to foreign companies, but restrictions, mostly on geographic expansion and ownership, remain in place that prevent foreign players from competing on a level playing field with local companies. Initially, only five cities were open to foreign insurers: Shanghai, Guangzhou. Dalian, Shenzhen, and Foshan. This was followed by the opening of another 10 cities: Beijing, Chengdu, Chongqing. Fuzhou. Suzhou, Xiamen, Ningbo, Shenyang, Wuhan and Tianjin.

In 2004. all geographic constraints were lifted, but foreign insurers applying to enter new geographies still need to secure regulatory approval from all tiers of CIRC, the insurance regulator, at central, provincial, and city level. The entire application process can take years and the number of new provinces and cities that a foreign player can enter in a given year has in effect been limited to three to six cities per year.

In a market where the bulk of growth is expected to come from hundreds of second- and third-tier cities, this restriction severely confines the capability of foreign players to capture top-line growth at a national level quickly. As a result, the combined market share of all 24 foreign companies was only 8 percent in 2007, with AIA accounting for 1.8 percent and every other player remaining below the 1 percent mark.

Consequently, the China insurance market remains dominated by the domestic "Big 3" players, with a combined market share of 70 percent in 2007. While, to some people, names such as China Life, Ping An, and China Pacific are still not familiar, these dominant Chinese players have grown to enormous size and have begun to wield their newfound clout, leveraging their domestic strength and high valuations to make investments globally.

However, the competition has been catching up. In 1988, the Chinese government opened the life insurance market to domestic competition but at first only allowed another two competitors - Ping An and China Pacific.These two first movers, along with the state-owned incumbent, China Life, dominated the market in the early 1990s. Gradually, regulators allowed more companies to enter the market and, in 2001, foreign entries increased as a result of China's WTO accession. This has led to a systematic loss of market share for the Big 3 within the past several years.

In 2007, China Life controlled only 44 percent of the market, down from 57 percent in 2001. If we add Ping An and China Pacific, the combined market share of all three declined from 95 percent in 2001 to 70 percent in 2007. This loss in market share was particularly acute in the large cities where droves of foreign insurers entered (for example, Shanghai), and was aggravated by the fact that the Big 3 - after their rapid expansion based on the growth of enormous, nationwide sales forces faced significant organizational strain in managing their huge and rapidly grown organizations. The numbers testify to the enormity of this challenge: China's new-agent turnover rate was 80 percent, compared with 20 percent in Europe's more mature markets - and agents are counted in the hundred thousands.

In their own ways, the Big 3 have been forced to retrench and fortify their positions. Ping An, for example, consolidated and downsized its agent sales force from over 267,000 in 2001 to less than 200,000 in 2004 in order to improve agent productivity. China Life has also slowed the growth of its agency force, although not to the extent of Ping An. And their public listing has further accelerated their transition from a pure, growth-focused, "landgrab" mindset to a focus on value creation.

Consequently, they stayed away from some of the fastest-growing but less profitable segments in the market, such as bancassurance and group business. This has created opportunities for local and foreign competitors to build share in the market.

As the growth of the Big 3 slowed, domestic attackers captured a greater share of the growing pie. In 2007, their combined market share was 22 percent, up from 8 percent just five years before. More significantly, the number of local players also multiplied. Whereas in 2002 there were only six local life insurers, including the Big 3, by 2007, there were 28 active players. Among the new players are New China Life, Taikang Life, and Taiping Life, who have built national presences and a market share of around 3 - 7 percent each.

They have managed to succeed by heavy reliance on bancassurance and aggressive investment-linked sales. As much as 80 percent of the business of newer players is derived from participating or investment-linked policies, while China Life and China Pacific have only just begun to offer investment-linked products. In addition, these attackers relied heavily on poaching executives from the Big 3 to fill their talent ranks - the entry of these domestic attackers has greatly exacerbated the talent problem in the Chinese life insurance market.

However, this batch of small but rapidly growing domestic players, are also beginning to face some of the problems confronted by the Big 3.They too find the rapid growth of their organizations and agent networks unwieldy and difficult to control. Having jumped from being small, nimble enterprises into larger, more bureaucratic organizations, they now need to relook at their management style and standardize their operating model. Without this exercise, many of these players will find it hard to sustain the high levels of growth they have enjoyed in recent years.

Not all attackers are successful. While companies like New China Life, Taikang Life, and Taiping Life have pulled away from the pack, many local attackers' market share is still below the 2 percent mark. With distribution forces numbering in the hundred thousands, the market leaders still dwarf the smaller players, giving them a big advantage in reaching into Chinas fast-growing, third-tier cities and even its rural areas. For example, Taiping Life has 44,000 agents spread across the country, compared with China Life's 680,000 agents.

Returning to the category of foreign players, all is not lost. If we look at the cities where foreign companies had more access and a longer history; their market share is significantly higher, implying that the regulations mask the true level of success for these players. Between 2001 and 2006, foreign insurers collectively entered approximately 30 cities in China. As in many other markets, once the markets were accessed, foreign players would capture market share through better execution than the locals.

During this period, foreign players grew 4 percent in market share, or 53 percent compound annual growth. In terms of new business, the foreign share will of course be even higher, although this data is not published in China. For example, in cities where foreign companies have had time to establish a presence they have performed extremely well, generating 30 percent of gross premium in Shanghai by 2007 and 23 percent in Beijing.

Generally foreign players are more focused on sales of investment linked products than their local competitors, which led to strong growth on the back of high-performing stock markets during 2004-07. In 2006, 31 percent of their combined premium portfolio was derived from investment-linked policies, as opposed to 10 percent for domestic companies. Consequently, they have managed to secure 16 percent of the 2006 market in these products. It is important to note that in a downturn scenario in equity markets - as we are experiencing at the time of writing-these portfolios are usually the hardest hit. How sustainable this strategy is in a bear market depends on the quality of the sales force.

The foreign players' journey in the China market is not without its challenges. The key challenges all involve people and regulations. On the people side, recruiting the right executives to manage the sales force and develop the newly licensed cities is proving to be a major challenge. When we study the performance of various foreign players in China, it is striking how much the quality of the specific management team in each city determines the success of that multinational in that specific geography.

It is not uncommon to find a foreign player perform very well in one city and very poorly in another - and the key difference centers on a few top local executives. In addition, recruiting sales agents at a rapid pace is also increasingly difficult. A few foreign players have tried to develop a higher quality agency force based on better agent qualification and training, with hopefully less turnover.

But so far no one has succeeded in enlarging this kind of model to a relevant scale. On the regulatory side, with restrictions on rolling out to tier two, three, and four cities, foreign insurers are still struggling to establish critical mass across China in their geographical footprint. Most foreign insurers have underestimated the challenges in dealing with the regulator.

With these obstacles, foreign insurers are likely to remain marginal players in terms of national market share in the medium term, but their growth rates will likely remain above the national average in cities where they have a presence.

For foreign companies still not in the market this may be the last boarding call. There are now 24 foreign companies in the Chinese market and as they become better established, the winners will pull away from the also-rans. The coastal markets are already nearing saturation; competition is both intensifying and moving further inland. The new wave of foreign joint ventures are increasingly looking further afield, either northward to the northeastern provinces (for example, Jilin, Heilongjiang, and Liaoning), or westward, most notably to Sichuan.